A Walk Through the Term Sheet (Bridge loans)

May 20, 2008

As part of my experience at SR One, I waded through 30+ term sheets for portfolio companies as well as deals in diligence and ones that were passed on. After looking at enough term sheets, you start to get the idea about what is market, what is desired, and why you put in one term or another. For a lesser experienced VC or an entrepreneur going through his first or even fourth VC funding round, you might not understand all of the terms and how they interplay. I’m going to attempt to demystify the process by describing each term and how it fits into the picture. I created a fully integrated financial model that spits out the returns waterfall for a range of exit values taking into account every financial term that can be modeled. This took hundreds of hours and still needs a few more details added. While I cannot send this model to anyone, I can describe how it works. If you have any comments or think I left anything out, by all means, shoot me an email, and I’ll mention it.

We’ll start with the seed stage bridge loan. Why? Because. It’s what most biotech companies get when they receive angel or seed stage money, their first financing. Most early stage biotech investors do not set a price on their financings. This is because their valuation will likely be wrong or above what a professional VC would set for a similar stage investment. The last thing you want as a very early stage investor is a down round right out of the start gate. Often the early stage investors do not have enough capital to put up after the seed round. This would cause them to get crushed on valuation since they can’t pay to play. Rather than be at the mercy of these new investors, a bridge financing is used instead.

These investments are usually structured such that the investment (anywhere from a few hundred thousand to a million dollars), converts into the first institutional round of financing either at a discount to that round (25% is typical) or with warrant coverage (additional option shares issued on top of the shares received for the investment). This compensates the investor for the earlier stage nature of this investment while avoiding setting a price.

One caveat on this for investors is to ALWAYS set a default valuation for conversion if the company never raises additional financing. If the company gets bought out before any institutional financing is secured, you can be stuck with just a debt note to be repaid with interest rather than a note convertible into a certain percentage of the company’s equity. Since a price was never set, you don’t know how much of the company it is worth unless you specify the default valuation. This has happened to early stage investors I know so learn from their mistakes.

Other bridge loans are used by insider VCs who need to give the company more money before the next financing. Often they did not get to their data, which would provide the value inflection point. As such a bridge loan, often convertible into the next round of financing either at a discount or with warrant coverage, is employed to “bridge” the company to the next round. Some VCs dribble money into the company over multiple bridges, which I think is counterproductive and a waste of money (legal expenses). Next topic, liquidation preference and participation.